Edward Poll is a certified management consultant in Los Angeles. He is the author of Secrets of the Business of Law: Successful Practices for Increasing Your Profits and The Profitable Law Office Handbook: Attorney's Guide to Successful Business Planning. If you have comments about this article, call 800/837-5880 or send e-mail to edpoll@lawbiz.com.

If you dread each spring's ritual to pay the tax man, you're not going to like what's coming next year. Effective for calendar tax year 1998, a new section of the Internal Revenue Code-6045(f)-will change the way income to lawyers is reported.

The new provision requires insurance companies and other settlement payors to report to the IRS on information form 1099-B all payments to lawyers, even if most of the amounts end up with the client. The new provision also removes the exemption for professional corporations. In other words, it doesn't matter whether you're incorporated or not. If you're a lawyer, payments made to you in connection with legal services may now be reported to the IRS.

While most businesses or individuals have been obligated to report payments to vendors totaling at least $600 in one year, lawyers have typically been excluded since those providing the information to the IRS could not determine the lawyer's share of any award or settlement. No more. This new provision specifically targets lawyers who have been criticized by the law's sponsors for not accounting properly for funds placed under their control.

Problems for Lawyers

There is a feeling by many lawyers that this new provision is only of concern to contingency practitioners. Not so! Any lawyer who receives settlements in contingency lawsuits, debt collections, real estate settlements, or family law matters-in other words, any lawyer with client trust accounts-may now have the entire award or settlement reported to the IRS on information form 1099 (the lawyer also receives a copy). Even if the amount that is intended for the client is not taxable, this does not alter the impact on the lawyer. The entire amount is to be reported to the IRS by the payor. And the IRS will now be able to check whether lawyers have recorded these payments as income on their tax returns. Failure to match lawyer 1040 income with payor 1099 expenses is likely to cause an audit.

Things get even more confusing when you realize that in many cases, the client's portion of any such payment is technically not an expense for the lawyer. In accounting terms, the client's portion is a liability, and as a liability, it cannot be reported on the expense side of the lawyer's tax return. This, in turn, will cause a wide variance in the income and expense items expected by the IRS as a result of the 1099 forms.

While it's clear that the issue can be explained by the lawyer, this would take place after an IRS audit began, and once begun, the agency can extend its fishing net to other areas of the lawyer's practice as well. Even if no new tax is found due, the mere fact of an IRS audit will surely cause additional expense to the lawyer that is not billable to anyone, not to mention the trauma and aggravation of having "Big Brother" snooping through the records.

And as a final wrinkle, current licensing or state laws may require that the lawyer include the entire 1099 portion as part of his/her gross receipts. If states receive information from the IRS to coordinate their tax collection efforts, and if the lawyer fails to match the 1099 reported income with his/her gross receipts tax filing with the state, another audit is possible.

What Can You Do?

Here are several possible strategies that might be utilized to mitigate the new tax reporting requirement:

· One approach is for the lawyer to request that the payor make out two checks, one payable to the client and one to the lawyer, each in the amount to which the recipient is due. If this does not violate confidentiality (amount of fee paid by a client to a lawyer) or other privilege, and if the payor will cooperate, the check payable to the lawyer, presumably with previous client approval, can then be deposited in the lawyer's general account. The check made payable to the client can be delivered directly to that client.

One drawback to this approach, besides a lawyer's not wanting to divulge the amount of his fee, is when a third-party lien or other distributions are to be paid from the client's share of the payment. The check may then have to be paid into the client's trust account for distribution at a later date. This may again trigger the issuance of a form 1099.

· A second method may be to have the payor prepare a check to the client for the entire amount, expecting the client to then make payment to the lawyer for her fee. This, of course-besides passing the full 1099 burden onto the client-ignores the human element: The client with the check now has the power to renegotiate the lawyer's fee, e x post facto. This method also ignores the consequences to the lawyer when a notice of a third-party lien has been received. And even if the client is good-intentioned and makes payment to the lawyer, what happens if the client's bank account is attached before the lawyer can deposit the check?

· Yet another approach is to have the client agree to receive a 1099 from the lawyer for that portion that is the client's share (including any liens that are to be deducted). This, again, may protect the lawyer after the audit has begun. But it may have disastrous consequences to the client in terms of apparently inflating his income. When the amount paid to the client is not taxable income (per the code), and the client receives a 1099, the client will be subject to IRS audit! Furthermore, where the client is receiving government or other assistance dependent on his income, receipt of a form 1099 for non-taxable income may cause havoc.

· The final-and the best-recommendation is for the lawyer to institute a very clear accounting procedure or "paper trail" to clearly delineate which portion of each check was passed on to the client, and which was retained as the lawyer's fee. Lawyers who have had sloppy bookkeeping habits before (remember the old shoebox approach?) will have to clean up their acts or face the consequences with the IRS. Only good, accurate bookkeeping will succeed in tracing the funds so that the lawyer is not obligated to pay tax on the entire amount received. Under all circumstances, one suggestion should be followed: Lawyers should attach an exhibit to their tax returns that reconciles all funds received (as reported on 1099s) and all payments made to clients (without disclosing their names), showing the net difference retained by the lawyer as "net gross income," my new term to define real gross receipts.

A Silver Lining?

Many sole and small firm practitioners will find that the new bookkeeping and paper-trail requirements will add another level of cost to their operations. But while the new tax provision may be ill-conceived and burdensome, creative minds will find a way to turn this into an opportunity to demonstrate effective client relations. This new law provides lawyers with another opportunity to enter into a dialogue with their clients, making them aware of the consequences of the law, examining the ethical issues involved, and perhaps telling them that they will not be billed for this extra work. CL